Building, Balancing, and Rebalancing A Mutual Fund Portfolio

You’ve read up on mutual funds and you’ve picked a small handful out that you want to invest in. Now what? How can you buy in incrementally and then keep them balanced over time? Here’s a great strategy for building up the portfolio the way you want it, getting it balanced right, and then keeping it balanced.

Your first step is to figure out the percentages you want in each fund. This is a personal decision, but I would recommend for most people that they have at least 30% in fairly aggressive funds (I have 60% in my target portfolio) and at least 10% in something pretty conservative that will weather a bumpy ride.

For an example, I’m going to use the portfolio that I am shooting to achieve in the next three years for my home investments (which have a fifteen to twenty year timetable before I completely cash out):

Next, figure out how much you need to actually build the portfolio. In other words, find out the minimum investment needed for each of the funds you’re going to invest in, then use that to determine how big your “starting” portfolio has to be. For me, all of the funds cost $3,000 to buy in, so that means I need a total investment of $30,000 to build that portfolio. In terms of starting dollar amounts, I need to look something like this:

There’s another factor, though; Vanguard charges $2.50 a quarter for each fund you hold that’s under $10,000, and so I should start these $9,000 funds at $10,000. So here’s my actual position that I plan to start with:

Once you’ve got the dollar amounts figured out, start investing in the funds. You’ll hear a lot of opinions on the order you should invest in. My feeling is that there should be one in your portfolio that you consider to be your “anchor” – not too risky, but not too conservative – and that’s the one you should start out in. For me, it’s pretty obvious – it’s the Vanguard 500.

I don’t have enough money to buy into the fund I want! Open up a high yield savings account, like one at ING Direct (the one I use) or HSBC Direct (another good one), and start putting money incrementally into that account until you can cover the minimum, then start buying the fund directly with those same increments until you reach your target. Then repeat the process with the other pieces.

Should I literally build a piece until I reach my target dollar amount? Some people might want to build a portfolio piece to near their target value and then move on to another. To tell the truth, either approach is fine. My plan is to build each piece up to their “starting” amount and then just let it ride while I build up other pieces. Once I have all of the funds with at least their starting amount, then I’ll do a rebalance soon after.

OK… what’s a rebalance? Let’s say I go through those investments in order and buy in to my target amount in each one. Obviously, I will have been invested in some funds for longer than others, and when I get done building all of my positions, hopefully some of the earlier funds will have grown a bit. Let’s say, hypothetically, that I finally get my portfolio built in December 2009 with a buy in on VBLTX and the balances look like this:

To do that, I have to sell $1,500 in the Vanguard 500 and put $1,000 of it into the small cap fund and $500 in the bond fund. I just sell shares that minimize my capital gains tax incurred and reinvest it so that I again have my target portfolio.

When should I rebalance? To be honest, in reality, I probably wouldn’t rebalance that above portfolio. My rule of thumb is to check the portfolio every six months and if a holding is more than 5% off of my target, I rebalance it so that all funds are at or near the percentage I want. Basically, I just convert the entire portfolio to percentages (like I did above) and then compare each percentage to my target percentage. If there is a more than 5% difference, then I rebalance; otherwise, I let it sit.

Why? Basically, rebalancing leverages risk. At different times, some funds will outperform others – this just ensures that you can take gains out of funds that are very volatile and also buy in when some funds are underperforming. In other words, rebalancing is a way to buy low and sell high, at least in comparison to the rest of your portfolio.

Here’s something I consider very carefully when I work on rebalancing my portfolio — I hardly ever sell due to tax considerations. So that I don’t incur a tax I stay put in my positions. Then I simply buy and add into underrepresented positions with new money/income (from job/business, etc) until the portfolio balances out. That’s been my strategy all my life and it has worked out well.

Secondly if I were to do the bulk of my rebalancing which involves selling, then I do so using my retirement accounts, again to avoid the tax implications from the gains….

Hey Trent, I like this post. I’d like to point out that there are some companies like T. Rowe Price who will let you buy into their funds with as little as $50 a month per fund (you can even do $50 per year if needed) with no fees for doing so. By using their Automatic Asset Builder program, investors can skip the high-yield savings account step and begin a regular investment program in high quality funds. The expense ratios for their funds aren’t bad either.

I originally wanted to go with Vanguard (still do), but couldn’t afford a lump sum of $3000, so I went this route and I think it could work for some of your readers if they’re in my situation. I was always told that investing as soon as possible is key.

Vanguard’s Target Retirement Funds will do the asset allocation and rebalancing for you. These Target Retirement Funds are funds of funds. Example the Target Retirement 2050 fund is made up of five Vanguard index funds:
72.2% Vanguard Total Stock Market Index Fund
10.2% Vanguard Total Bond Market Index Fund
10.2% Vanguard European Stock Index Fund
4.7% Vanguard Pacific Stock Index Fund
2.7% Vanguard Emerging Markets Stock Index Fund
The beauty is the minimum investment is only $3000., there is no quarterly fee and the expense ratio is only 0.21%.

Don’t wait to invest based on the $10 fee. If the market goes up 10% this year, and you don’t invest the $9,000, you could have made $900 in the market, then paid $10 in fees, for a net $890. If you put it in a 5% savings account, you’ll make $450 this year. You’ll lose $440 trying to save $10. You might pay a few dollars to Vanguard, but you and Vanguard will both make out better in the long run if you invest when you have the money.

Trent, your set of 4 funds completely omits the Small Cap Value portion of the U.S. stock market. Just curious if there is a reason for this.

Historically, that quadrant has performed better over the long term than any of the other three quadrants of the U.S. stock market (i.e. Small Cap Growth, Large Cap Growth, and Large Cap Value), so if anything, I would want to overweight Small Cap Value, not leave it out of my portfolio!

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